To deduct or not to deduct Featured

9:58am EDT July 22, 2002

As home-based businesses continue to grow, a new rule, which took effect Jan. 1, 1999, has made it easier for business owners to deduct their home offices. But how does this change affect the average business owner? And, perhaps more importantly, is it worth it?

The new rule allows business owners to take a home office deduction if:

1) They use their home office for administrative or management activities on a regular basis.

2) They don’t have another “fixed location” where they do a large portion of their administrative and management activities.

Managerial and administrative activities include billing, book and record keeping, ordering supplies, making appointments, forwarding orders, or writing reports. A “fixed location” would be another office. Cars and hotel rooms do not qualify as “fixed locations.”

You’re still eligible for the home business deduction under the new rule even if you:

  • Outsource certain administrative or managerial tasks such as invoicing;

  • Perform administrative or managerial tasks in “non-fixed” locations such as a car or hotel room; and

  • Choose to work from home, even if a suitable “fixed” space is available outside the home, but used only on an occasional basis. The amount of any home office deduction would still depend on the size of the office as compared to the rest of the house.

This may seem like a wonderful tax break for professionals who work primarily out of their homes, but is it worth it? That depends.

From the perspective that you would, in fact, receive a tax deduction, the home office deduction may be worth it. However, the home office deduction may decrease the amount you can save under the new capital gains law that was passed by the Taxpayer Relief Act in 1997.

If you are deducting a portion of your home under the new home office rule, the part being deducted would be taxed at a special 25 percent capital gains rate if the house is sold. Here’s why. To qualify for the homeowner’s $500,000/$250,000 capital gains exclusion, the property must have been your primary residence for two of the last five years before the sale.

According to many experts who have analyzed these new rules, if the home office has been in use for more than three of the five years before the sale, the square footage being used for the office of the home will not qualify for the new capital gains exclusion and will be taxed at the higher capital gains rate.

If the office square footage is taxed at the higher rate and the house will be sold in the near term, the depreciation deduction is probably not worthwhile. On the other hand, the home office deduction is worth it if you’re not going to sell your home in the near future.

Louis P. Stanasolovich is founder and president of Legend Financial Advisors, Inc., a fee-only North Hills Securities and Exchange Commission registered investment advisory firm that provides asset management and comprehensive financial planning services to individuals and businesses. Reach him at (412) 635-9210. Legend Financial Advisors, Inc.’s Web address is www.legend-financial.com.